Needed for 2013, a paradigm change

How do you judge the health of an academic discipline? Is macroeconomics rotten or flourishing? Stephen Williamson is right that in one sense it is flourishing: many interesting avenues are being explored, and lots of interesting papers are getting written. Furthermore there is a common language. Of course there are pronounced local dialects, but there is mobility to, so having a freshwater dialect does not stop you giving a seminar that will be appreciated in a saltwater department, or indeed working in a saltwater department. So as an intellectual pursuit, one could claim that times have never been better for academic macro.

Society does fund some academics to engage in purely intellectual pursuits, but macroeconomics is not one of these. Yet much of the flourishing of ideas and research that is currently taking place has been inspired by recent events, and is directly or indirectly policy relevant. However having lots of ideas that are relevant to policy is not sufficient to make an academic discipline useful. It also needs to respond to the evidence in sorting out what ideas are helpful and what are not, so that it can be a progressive endeavour. In this respect, academic macroeconomics appears all over the place, with strong disputes between alternative schools.

Is this because the evidence in macroeconomics is so unclear that it becomes very difficult to judge different theories? I think the inexact nature of economics is a necessary condition for the lack of an academic consensus in macro, but it is not sufficient. (Mark Thoma has a recent post on this.) Consider monetary policy. I would argue that we have made great progress in both the analysis and practice of monetary policy over the last forty years. One important reason for that progress is the existence of a group that is often neglected – macroeconomists working in central banks.

Unlike their academic counterparts, the primary goal of these economists is not to innovate, but to examine the evidence and see what ideas work. The framework that most of these economists find most helpful is the New NeoClassical Synthesis, or equivalently New Keynesian theory. As a result, it has become the dominant paradigm in analysing monetary policy.

According to Scott Sumner the dominant paradigm is not very useful, in fact quite useless

Of course private industry doesn’t use DSGE models, they are useless. The macroeconomy is incredibly complex; I recall McCallum once listing 10 types of wage/price stickiness. Most models assume one type. And most models fail to incorporate AD/AS interaction, as when adverse demand shocks reduce AS by leading policy-makers to extend unemployment insurance from 26 weeks to 99 weeks. Most don’t know how to identify monetary policy shocks. The DSGE models are incredibly simplistic. I basically “retired” from mainstream macro several decades ago when I saw where things were going, and pursued my own research interests.

There are two possible uses for DSGE type models; identify the costs of macro instability, so that central banks can pick the optimal target, and identify the stance of monetary policy most likely to hit the policymaker’s target. But the DSGE models cannot do either. The optimal monetary policy stance is most efficiently resolved by targeting market forecasts of the goal variable. And given the complexity of the macroeconomy, any attempt to use DSGE models to identify the optimal monetary policy goal will depend entirely on what assumptions are built into the model.

The real problem with mainstream macroeconomists is that they are too influenced by “framing effects” and had a giant brain freeze in late 2008. Virtually the entire profession forgot that the central bank has the ability and responsibility to provide an adequate level of AD. Only a fringe group of Aspergy-types looked beyond the framing effects, saw the real problem, and saw what needed to be done. But the profession (freshwater and saltwater) failed us. The central banks do pretty much what a consensus of elite macroeconomists think they should be doing. The profession “owns” the Great Recession, or at least that portion of it caused by inadequate AD. The profession has had the tools all along, but doesn’t seem to know how or when to use them. Only 4 years later is it starting to wake up.

3 thoughts on “Needed for 2013, a paradigm change”

A growing consensus for Market Monetarism and yet it all still feels a bit fragile, doesn’t it. As the New Year progresses, hopefully we’ll all have a better understanding how to proceed! Happy New Year to all.